The terms and jargons in the financial world can be quite confusing. At times, their meanings can be muddled by different approaches that investors use. One such term is financial instruments. 

In this article, we’re going to talk about what financial instruments are and their qualities in the financial markets. Read on! 

What is a Financial Instrument? 

 

A financial instrument is essentially an asset that you can trade. Sometimes, investors consider capital packages as financial instruments too, as long as they can trade it.

Among the most common kinds of financial instruments are cash, a contract, or ownership. But generally, financial instruments are either of two types: cash instruments and derivative instruments. 

Digging Deep into Financial Instruments 

Financial instruments are either real or virtual documents that represent a legal agreement that involve any kind of value in terms of money.

For instance, equity-based financial instruments represent the ownership of an asset, often the shares or equities of company’s stock. 

Financial instruments can also base on debt. In this case, the financial instrument represents a loan that an investor made to the owner of the asset. 

Another type of financial instrument is the foreign exchange-based asset. This comprises a third, unique type of financial instrument. 

Furthermore, different sub-categories of each financial instrument are also available to investors. Examples include common share equity and preferred share equity. 

2 Types of Financial Instruments 

As we have mentioned, there are generally two types of financial instruments. These are cash instruments and derivative instruments. 

Cash Instruments 

The markets directly affect and determine the value of cash instruments. At the same time, these securities are often very liquid assets.  

High liquidity means it’s easy for investors or traders to exchange the assets for cash. The faster you can convert it to cash, the higher its liquidity level is. 

Cash instruments can also be in the form of loans and deposits that the borrowers and lenders agreed upon. 

Derivative Instruments 

Derivative instruments derive their value and characteristics from the instrument’s underlying components or assets. 

These assets, in turn, can be anything that has value such as stocks, bonds, and commodities. Moreover, derivative instruments can also base their value on interest rates and indices. 

Traders can trade these instruments on the OTC (over-the-counter) markets, meaning investors can buy or sell them without intermediaries. But some types are traded on exchanges too.

Asset Classes 

You can also categorize financial instruments according to asset class. 

Debt-Based Financial Instruments 

These can be short- or long-term financial instruments. The short-term ones typically last for one year or less. Examples include Treasury bills and commercial paper. 

Long-term ones can last for more than a year. These can be bonds, cash equivalents, bond futures, and other similar assets. 

Equity-Based Financial Instruments 

Equity-based financial instruments are generally stocks. These can also come in the form of exchange-traded derivatives like stock options and equity futures. Among OTC derivatives are stock options and exotic derivatives. 

Foreign Exchange Securities 

Under the foreign exchange market, there are no real securities, since you don’t own the currencies when you press “buy” on the trade. 

Learn the basics of Finance Products and Labrich Trading Strategies by studying the historical events that have shaped our world giving you a better understanding of trading and what drives volatility.